America First? Why Tariffs Have Proven to Be Ineffective in the Past

Ever since the end of World War II, the United States has largely been a proponent of economic liberalization, especially with the respect to trade. The reasons for this are two-fold: One, market integration promotes peace (finally the end of large-scale armies invading neighboring countries). Two, liberalization helps stimulate the global economy. With the creation of the World Trade Organization (WTO), the World Bank, and the International Monetary Fund (IMF) after World War II, global integration became the norm.

Liberalization was also largely bipartisan in the United States. In the 1980’s U.S.’ President Ronald Reagan and the UK’s Prime Minister Margret Thatcher both promoted another form of liberalism (called neo-liberalism) by further deregulating financial markets and cutting back on government spending. Even though President Clinton increased taxes on the upper class, he still made significant cuts to the federal budget, which helped erase the federal deficit in the mid-1990s – a fiscally conservative move. The North America Free Trade Agreement (NAFTA) entered into force in 1994, the first year of President Clinton’s first term. President Obama was also a stark proponent of free trade by orchestrating and taking a leading role in the Trans-Pacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership (T-TIP).

After several decades of U.S. policy promoting free trade and liberal markets, President Trump has gained political momentum by promoting “America First” trade policies. In his first few months as president, Donald Trump withdrew the United States from the TPP, informed Congress that he intends to begin new negotiations with Canada and Mexico on NAFTA, and is currently considering raising tariffs on a number of imports by as much as 20%. As these policy moves are supported by President Trump’s passionate voter base, which largely consists of blue-collar manufacturing workers in the industrial Midwest, who have suffered from liberal trade policies without recourse, there could be global implications, just as the world economy is building up steam.

Smoot-Hawley

The United States implemented similar protectionist policies nearly 90 years ago. After the Democrats gained control of Congress and the White House in 1910 and 1912, the 1913 Underwood-Simmons Tariff became law, lowering tariffs to promote global trade. From after the civil war to then, the United States government largely relied on high tariffs to fund the national government. As a result of the cut in tariffs, and, therefore, revenue, the Democrats re-instituted the federal income tax, ratifying the 16th Amendment.

The experiment of low tariffs ended in the 1930’s, however, when Congressmen Reed Smoot and Willis Hawley formed what is frequently referred to as the Smoot-Hawley Tariff Act of 1930. Congress wanted to raise import duties in order to protect domestic businesses and family farms from international trade. As Europe began recovering from World War I in the mid to late 1920’s, European farmers increased output, saturating the agricultural market, and threatened domestic production. By 1928, President Herbert Hoover promised to increase tariffs on agricultural goods. However, other sectors wanted protection from global competition, so several more tariffs also ended up increasing – about 890 to be exact. By 1932, the average American tariff was 59.1%, the highest since 1830.

Reaction to Smoot-Hawley and the economic consequences

As the United States sought protection from global trade, foreign governments retaliated. As many as 24 countries established similar, reciprocal tariffs – Spain, Italy, and Switzerland – which ultimately resulted in a trade war. Even Canada responded, raising tariffs on a variety of United States’ goods, while cutting tariffs on goods from the UK.

Despite trade being a bit more limited than it is in today’s world, there were negative consequences to the global trade war that erupted. However, that doesn’t mean that there were no negative implications from global trade retaliation. In total, the Smoot-Hawley Tariff Act increased import duties by an average rate of nearly 20 percent. As a result, the relative price of imports increased 5 to 6 percent, just from the tariff increases alone. Exports also took a tumble, falling 75 percent in the first quarter of 1929 to the first quarter of 1933. (The index equals 100 in the final quarter of 1928.) As we see in Exhibit 1 below, exports were suppressed until the Reciprocal Tariff Act, which gave the President authority to negotiate bilateral trade deals, was passed in June 1934.

As exporters were struggling to stay afloat, so too were consumers. U.S. consumer outlays fell 9.38 percent year-on-year in 1931 and 10.79 percent in 1932. As consumers began to drastically slow their spending, inflation followed suit. By the summer of 1930, the U.S. was in a dire deflationary period, with inflation rates declining 4 percent. Inflation would eventually reach -10.74 percent in October 1932, the lowest level during the Great Depression, with deflation lasting until late 1933.

It is relatively clear from an economics standpoint that the Smoot-Hawley Act of 1930 had a negative impact on the economy. Exports declined and consumer spending dropped sharply, which are both indicators that the tariffs had an effect. A political economy that called for protectionist trade measures only added to the significant decline in output during the Great Depression.

Tariffs have been tried more recently

In March 2002, President George W. Bush sought to protect American steel producers from global competition by imposing a 30 percent tariff on foreign steel, which was a significant increase from less than 1 percent. The tariffs were only intended to be a temporary measure, with an expiration set for 2005. However, the policy that was supposed to help the domestic steel industry ran into several road blocks.

As President Bush raised tariffs on steel, many countries in Europe, South America, and Asia were affected by the increase in U.S. steel tariffs and sought to fight back. After several countries filed suit with the WTO, it was declared that the tariffs were in fact illegal in 2003. The EU, Norway, South Korea, China, and Brazil (among others) issued a joint statement welcoming the WTO’s decision. In fact, the ruling allowed these countries the legal right to retaliate. The EU threatened to impose sanctions in response, worth $2.2 billion. The EU was prepared to hike tariffs on several U.S. goods ranging from agricultural products, motorcycles, and various articles of clothing, which would have decimated several U.S. manufacturing sectors.

Tariffs also had economic consequences. Approximately 200,000 people lost their jobs in the steel industry, which was largely due to higher prices caused by the increase in tariffs. In addition, there was an estimated $4 billion dollars of total lost wages between February and November 2002. The price increase also pressured steel consumers by increasing their costs, which contributed to the U.S. steel industry’s demise in the early 2000s.

The Bush administration was eventually forced to lift the tariffs by December 2003 – 2 years before they were scheduled to expire. Feeling the pressure from global trade partners and beginning to see the economic effects surrounding the steel industry and its consumers, there was too much to lose by keeping the tariffs in place.

President Obama also imposed tariffs during his presidency, including Chinese-made tires. In 2009, President Obama imposed a 35 percent tariff on tires made in China, claiming that Chinese companies were dumping, or selling below U.S. market prices. The Obama administration stated that this action saved 1,200 U.S. jobs and paved the way for increased tire production in the United States. However, when there are winners, there are also losers.

In this case, the American consumer was the ultimate loser, paying 26 percent more for Chinese-made tires and 3.2 percent more on American-made tires. As a result of higher prices, consumer retail spending reduced by $1.1 billion, which translated to 3,731 retail jobs being lost. The U.S. economy growth is largely dependent on the American consumer (approximately 2/3 of total output is generated from consumption), and so increased tariffs too its toll on economic growth.

China also retaliated by raising tariffs on U.S. automobiles and poultry, creating a headache for U.S. auto manufacturers and farmers. In fact, the Chinese Ministry of Commerce announced in February 2010 that they would impose tariffs on U.S. chickens, with tariffs ranging from 50 to 105 percent. By December 2011, China had also hit U.S. autos with a 21 percent tax. In the end, the WTO ruled in favor of the United States’ tariff increase, but both sides faced an escalating trade conflict.

What this means today

All three of these examples have one similar theme: tariffs largely fail to protect the sector that they are intended to and, as countries often retaliate, this leaves several domestic sectors vulnerable to market distortions. In the case of Smoot-Hawley Tariff Act, the widespread use of tariffs essentially closed off global trade, which slowed consumption and likely worsened the effects of the Great Depression. More recently, President George W. Bush’s tariffs failed to protect the steel industry from global competition, and resulted in hundreds of thousands of jobs lost due to the price of steel increasing. Finally, President Obama inadvertently affected consumers by protecting the American tire industry, which largely had no net benefit to the aggregate economy. In short, tariffs have proven to be an ineffective tool when trying to protect domestic production, and often create global conflict – which is the last thing the recovering global economy currently needs.